IMF Proposes Bail-In Powers For Major Banks

4/24/2012 10:20 PM ET

Mandatory debt restructuring of systemically important financial institutions, or SIFIs, can protect taxpayers from exposure to bank losses, a study by International Monetary Fund staff revealed Tuesday.

According the IMF staff, large-scale government support of the financial institutions deemed too big or too important to fail during the recent crisis has been costly and has potentially increased moral hazard.

The so-called bail-in power allows a resolution authority to restructure the liabilities of a distressed financial institution by writing down its unsecured debt or converting it to equity, the report said.

These kinds of initiatives are intended to protect taxpayers from exposure to bank losses and to reduce the risks posed by too-big-to-fail (TBTF) institutions.

"By restoring the viability of a distressed SIFI, the pressure on the institution to post more collateral, for example against their repo contracts, could be significantly reduced, thereby minimizing liquidity risks and preventing runs by short-term creditors," the report said.

The staff, meanwhile, noted that special attention should be taken in triggering a bail-in power that it is not perceived by the market as a sign of the concerned institution's non-viability, which could lead to a run by short-term creditors and aggravate the institution's liquidity problem.

The removal of the too-big-to-fail premium will help restore market discipline by aligning bank funding costs more closely with risks. Moreover, bail-in could break the observed negative feedback loops between sovereign risks and bank funding costs, the economists said.

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